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For more than a decade, the Federal Energy Regulatory Commission has charted a course toward competitive markets in electricity generation as the means of ensuring reliable, lower-priced power for American consumers. But an increasingly congested transmission grid is pushing that destination farther away. Grid congestion blocks access for lower-cost generation, chokes off otherwise economic transactions, and thereby hinders the growth of truly competitive markets. The problem is serious. According to Department of Energy reports, congestion in many areas occurs more than half the time, costing consumers billions of dollars. A June 2004 report for the DOE and the Edison Electric Institute concludes: “The August 2003 blackout that hit the Midwest, Northeast and Ontario was a wake-up call on the U.S. transmission system. Whether one considers the transmission grid adequate, ‘fragile,’ ‘antiquated,’ or even ‘third world,’ almost everyone agrees that the electricity industry and government policy makers should pay more attention to transmission, in particular construction of needed new facilities.” And the amount of investment needed is substantial. The June report offers estimates ranging from $27 billion over the next several years, to $50 billion to $100 billion for the next decade. Yet failing to act will cost far more due to deteriorating reliability and higher prices. FERC recognized early on that adequate transmission was key to power markets that would bring together many buyers and sellers and let generators compete. In its March 1995 press release launching the “open access” rulemaking that led to Order 888, FERC said: “The goals of the new rules are to facilitate the development of a competitive market by ensuring that wholesale buyers and sellers can reach each other and to eliminate anticompetitive and discriminatory practices in transmission services. This, in turn, should lead to lower electric rates.” In initiating its next major rulemaking in 1999, FERC found that rapidly growing wholesale markets, where “power resources are now acquired over increasingly large regional areas, and interregional transfers of electricity have increased,” had put “new stresses” on transmission, but “planning and construction of transmission . . . may not be keeping up.” In the resulting Order 2000, FERC offered various incentives to encourage vertically integrated utilities to transfer control of their transmission to independent regional transmission organizations (RTOs) that could efficiently operate, plan, and expand the grid. Orders 888 and 2000 recognized that FERC’s competitive goals could not be met with a static grid. Order 888 placed express obligations on transmission owners to plan and expand the grid to meet customer needs. Order 2000 said that RTOs must have authority to plan and direct grid expansion. In applying Order 2000, FERC insisted that RTO planning and expansion focus broadly to “ensure that efficient investments are made to make generation markets more competitive, increase import capability and improve reliability.” Despite this clear recognition of the need for a robust grid, today its very absence increasingly limits supply choices, rendering competitive markets more dream than reality. What happened? Where did we lose our way? How do we get back on course? THE WRONG FOCUS FERC got side-tracked. The agency’s now-abandoned (at least in name) Standard Market Design proposal of 2002 still noted the need for adequate transmission infrastructure “to allow geographically broad supply choices.” However, viewing spot-market price signals as a virtual cure-all, FERC left it to individual market participants to decide whether to fix grid inadequacies through generation or transmission investment: “The ability of individual market participants to see the economics of possible solutions and make market-driven decisions concerning the addition of infrastructure is the fundamental mechanism that induces efficient investment.” FERC relegated regional planning to a clearinghouse function for identifying transmission needs that market players proposing generation or transmission solutions could compete to fulfill. The sharp corners of Standard Market Design were softened by FERC’s April 2003 Wholesale Market Platform White Paper, which restored a more proactive RTO planning process. However, the white paper distinguished between “reliability” upgrades to keep the lights on, which would be funded through rates, and “economic” upgrades to reduce congestion and support the market, which may be left to “participant funding.” As now implemented, participant funding depends on individual market players stepping forward to fund an upgrade. Instead of receiving the nearly assured return obtained by transmission owners, the funding entity writes the owner a check and, in return, receives rights to uncertain revenue streams based on congestion-created price differentials along the grid segments decongested by the upgrade. But no one has explained how this congestion-based revenue — which has been reduced or eliminated by the upgrade — can support the regionally significant grid investment required to make markets more competitive. Who would invest for that kind of return? Recent FERC orders have reinforced reliance on market solutions for congestion problems. For instance, in the PJM Interconnection (the RTO that includes the mid-Atlantic region), each economic upgrade must be supported by a cost-benefit analysis and a specific cost allocation. Then it is shelved for 12 months to give the market a chance to respond with alternatives. During the years taken up by this process, often-contentious siting efforts, and, finally, construction, consumers remain burdened by congestion. To induce generators to locate and operate where the congested grid cannot bring in economic electricity, FERC has pushed policies designed to let prices rise to “scarcity” levels. Under policies announced this year, transmission solutions, even to reliability problems, take a back seat to ensuring that generation prices reflect scarcity. This makes new transmission the problem, rather than the solution, for if transmission is built to relieve congestion, generation prices will drop and reduce scarcity revenues. It gives some industry participants an interest in maintaining congestion. A single-minded focus on generation solutions to congestion is analogous to saying that as long as a neighborhood has a few convenience stores selling eggs at some, albeit premium, price, there is no need to build a road to allow consumers to buy competitively priced eggs at supermarkets. Reliance on generation solutions also requires FERC to intervene in the market to ensure that scarcity prices are not thinly disguised monopoly rents. FERC’s assumption that spot-market prices will spur investment is being questioned. As a July 2004 Standard & Poor’s report explains: “Pricing data associated with hourly nodal prices should provide the market signals for use in planning for investment in transmission and new generation. Yet, generators may realize that the benefits will be ephemeral. Once generators build capacity in a load pocket to address transmission congestion issues, prices will likely reach equilibrium levels that could remove the economic incentives created by locational marginal pricing. Therefore, generators may forgo developing fixes if their investments might fail to provide them with economic benefits commensurate with development risks throughout the asset’s life. The same argument could be extended to developing transmission.” UNLIKELY SOLUTIONS If we’re going to rely on competitive generation to keep prices reasonable, we need to cut short this detour. Federal and state policy must get back on course to remedy transmission weaknesses that prevent generators from competing. We must make a commitment to transmission construction at a reasonable cost. (Too much expansion need not concern us; the difficulty of getting transmission sited and built makes that risk very small.) One solution that is unlikely to work, and may well backfire, is “FERC candy” — incentive rates of return and accelerated depreciation for ratemaking purposes. The agency’s 2003 Proposed Pricing Policy for Efficient Operation and Expansion of the Transmission Grid would provide such inducements, and FERC has approved them in some cases. However, these sweeteners burden consumers, adding to state resistance to transmission additions, while doing little to lower the real risks associated with transmission investment. In addition, they bestow competitive advantages on the vertically integrated utilities that receive them, while not overcoming the internal competition for capital within utilities whose generation benefits from congestion. As S&P’s report bears out, participant funding that relies on uncertain congestion revenues also won’t do the trick. The benefits of a transmission upgrade are many and difficult to assign, change over time, and can be enjoyed by “free riders.” Reliance on participant funding invites a game of chicken, where would-be beneficiaries sit back in the hope that others will bear the cost of an upgrade. It should come as no surprise that some of the strongest proponents of this approach are likely to benefit if new, lower-cost generation does not reach the market. FOR BETTER TRANSMISSION On the other hand, there are ways to overcome hurdles to transmission investment. (The following ideas are more fully explored in a June 2004 white paper by the Transmission Access Policy Study Group.) One structural solution is the stand-alone transmission company open to ownership by all area utilities. Because its sole business is transmission, grid expansion projects do not have to compete internally against generation projects, as they do within a vertically integrated utility. Nor is a stand-alone company tempted to avoid transmission investments to protect its generation from competitors. Inclusive stand-alone companies like the American Transmission Co. (operating in Wisconsin, Michigan, and Illinois) have attracted investor capital and enjoy solid credit ratings. Another structural solution is the shared or joint transmission system, of which examples exist in Georgia, Indiana, and the Upper Midwest. Two or more neighboring utilities contribute their transmission facilities to create a combined system. If open to all area utilities, the joint system expands access to capital, reduces regulatory conflicts, and facilitates siting decisions. Policy-makers should adopt regulatory solutions that promote transmission investment by addressing its risks, while minimizing costs to consumers. Regulators can mitigate the upfront risk that arises during siting and construction by permitting concurrent rate recovery of siting and construction outlays, instead of deferring cost recovery until a facility is built. Transmission’s steady revenue streams can be made to more closely track expenses through the use of “formula” rates, which avoid regulatory lag and costly proceedings. Equity returns used in setting transmission rates should be set commensurate with transmission’s low risk. Building on those steady revenue streams, regulators can develop and support investment trusts and other vehicles to attract outside capital from large investor pools, such as pension funds, looking for stable, low-risk returns. Where a vertically integrated utility will not build transmission without the promise of higher equity returns or accelerated depreciation, it could be required to bid out the capital component of the project and let the market determine the true cost of capital to build transmission. The cost of expanding parts of the high-voltage “backbone” grid should be spread across the region affected and not simply assigned to the area where the expansion is built. Spreading costs this way reflects the broad regional benefits obtained and should reduce opposition from local consumers and state regulators. Regulators should also insist on an open, regional planning process, which should help to ensure more broadly efficient solutions and to facilitate siting. Finally, regulators could approve performance-based rates to reward companies that reduce congestion costs, adopt inclusive planning processes, and open transmission investment to all area utilities, while punishing companies that perform poorly. Congestion in the transmission grid will — indeed, is — undermining competition. If regulators and policy-makers really want competitive generation markets to provide affordable electricity, they must find ways to foster a robust grid. Cynthia S. Bogorad is a partner and Mark S. Hegedus is of counsel at D.C.’s Spiegel & McDiarmid. They are counsel on electric restructuring issues to the Transmission Access Policy Study Group (TAPS), an informal association of transmission-dependent utilities located in 35 states. The TAPS white paper can be read at www.tapsgroup.org.

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